Can you benefit from municipal bonds?

By Jeff Hupman
Guest Columnist

POSTED:May 3, 2007 5:02 a.m.

You’ve almost made it through another tax season. If you are getting a refund, you might be pretty satisfied with how things turned out. But if you’d like to see a somewhat different outcome in 2008, you may want to review all areas of your tax return, including your investment-related taxes. As you may know, some investments are more “tax-friendly” than others are — and municipal bonds might be some of the friendliest ones of all.

If you aren’t that familiar with municipal bonds, here are the basics: Municipal bonds, or “munis,” are issued in two main categories: general obligation bonds and revenue bonds. General obligation bonds finance the activities of state and local governments, while revenue bonds pay for specific projects, such as airports, hospitals and other civic institutions.

So, when you purchase a muni, you’re supporting a project or service, possibly in your state or community. And you will be rewarded for your civic-mindedness — through tax breaks. Specifically, your interest payments will be free from federal taxes; if the municipality that issues the bond is in your state, your interest payments also may be exempt from state and local taxes.

Municipal bond interest is free from federal taxes, but some munis — particularly airport and housing bonds — might be subject to the alternative minimum tax (AMT). If you think you may have to pay the AMT — and a lot more people are subject to this tax now than in years past — you might want to avoid these types of bonds. Conversely, if you know you won’t be assessed the AMT even if you bought some AMT-subject munis, you might be especially interested in these bonds, because their yields are typically higher than the yields on regular municipal bonds.

In any case, municipal bonds offer some benefits beyond tax-free interest. For one thing, munis can help you diversify a portfolio heavily weighted with stocks. Municipal bonds may not be affected by many of the factors — such as poor corporate earnings reports — that cause volatility in the price of stocks. So, municipal bond prices generally do not move together with stock prices.

Furthermore, municipal bonds are among the most secure investments you can own. The default rate on munis — especially general obligation bonds — is typically quite low.

Which types of municipal bonds are right for you? Your choice depends, to a great extent, on your goals and investment personality. For example, longer-term munis — those bonds that mature in 10 years or more - will generally pay a higher interest rate than shorter-term bonds. Yet, prices of the longer-term offerings also may fluctuate more.

You may want to consider owning a variety of short-, intermediate- and long-term munis. This type of portfolio - known as a bond “ladder” - can help you in all types of interest-rate environments. When market rates are down, you’ll benefit by owning long-term bonds, which generally pay higher rates than short-term bonds. But if market rates are up, you can use the proceeds of your maturing short-term bonds to reinvest in issues with higher rates.

Finally, when you’re shopping for municipal bonds, look for quality — those bonds that are rated at least “A” or higher by the major rating agencies.

Municipal bonds occupy their own special niche in the investment world - and it’s a niche that you may want to explore further.